SAFETY IS FORMED FROM ACCEPTING RISKS
For every one hundred “fools” who dare to step forward, humanity takes one hundred steps forward.
On February 19, 2014, Facebook spent $19 billion ($12 billion in Facebook shares, $4 billion in cash and $3 billion in restricted stock) to acquire WhatsApp, a cross-platform messaging app from two of its founders Brian Acton and Jan Koum. Sequoia, WhatsApp’s sole venture capital fund, is probably the most satisfied party in the deal, having made $3 billion, reaping a 50 times return on the initial $60 million investment. According to CB Insights, WhatsApp is the most successful venture capital of all time, a glorious win for the Sequoia fund [1]. “High risk — High return” is probably a reasonable description of Sequoia’s investment decision for WhatsApp, also the general sentiment of venture investors.
Venture capital is funding that investors provide to startups and small businesses that are believed to have huge growth potential. This investment tends to be risky because startups are still in their infancy and can’t be certain about future success. Therefore, these deals are only attractive to those with a taste for venture capital, towards “high risk — high return”.
So, why do people take risks, and why are some people willing to take more risks than others?
1. To survive, humans must learn to take risks
The amygdala, located deep within the temporal lobe of the brain, plays an essential role in processing memories, producing emotions and making decisions [2]. When it senses danger, the amygdala reacts immediately, pumping adrenaline into the bloodstream continuously, increasing heart rate, sweating palms, tensing muscles, and triggering fight-or-flight responses. The faster the “fight or flight” response occurs, the more likely we are to survive individually and as the species as a whole. But this is a process that consumes a lot of energy and even negatively affects the organism itself. Therefore, it is only effective if activated when there is a danger greater than the risk to the organ systems from the increase in adrenaline. So, how do you know when it’s just wind-blowing grasses, and when it is a hidden tiger?
In addition to the immediate response system, organisms also develop another nervous system that is responsible for assessing hazards before the response system is actually activated. Almost every species with a highly developed nervous system evolved both of these systems, but humans in particular take system 2 to the next level. The evolutionary advantage of humans lies in the ability to analyze and evaluate risks thanks to the Neocortex. As the outermost layer of the cerebral cortex and making up 90% of the cerebrum [3], the neocortex is the latest highly evolved layer for intelligence and analytical abilities. It can infer, evaluate the environment and adjust behavior, it helps us to handle more scenarios, but also slower. Therefore, humans have two risk response systems: a primitive intuitive system that makes decisions almost instantaneously, and a more advanced but also slower analytical system. Both of these systems work almost simultaneously any time we are exposed to risk.
The amygdala will be overwhelmed if it is always in a state of making decisions for all kinds of potentially risky situations in life; The organism and the quality of life of the organism will also be affected. Therefore, to avoid constantly activating primitive mechanisms, people have better exposure to risk. Humans dare to do more, because the brain actually prevents us from doing risky things less than how the brains of wild animals work. The stress and “fight or flight” systems of wild animals are very sensitive. Meanwhile, people are persuaded by system 2 of the brain, helping them dare to step into the shaking grass, into the crowd consisting only of strangers or jump into the lake they see for the first time. Because risks don’t always become reality, so not everyone who dares to take risks is in danger.
The analytical system of the neocortex is still in its infancy with many evolutionary primitives, it only learned the trick of predicting the time and location of hazards before they occur a few million years ago [4]. So basically, not every reason it gives is valid. So while we always feel like we’re always making rational and calculated decisions, in reality, much of it is guesswork and we get lucky. But so what? At least humans have always allowed themselves to get lucky.
Because we are good at taking risks and always ready to engage in activities with uncertain results, we have reached further than any other species on this planet.
2. “High risk & High return”
Since the 1970s, many researches on risk have gradually gathered and developed into an interdisciplinary field of study. The definition of risk can involve ethics, epistemology, philosophy of science, philosophy of technology, and philosophy of economics. Psychology has done a lot of research on how people perceive and assess risk, and more specifically on finding an intrinsic correlation between risk and reward. Basically, a “risk” will exist in the uncertain future, which can only be judged based on experience or current data. Therefore, learning about risk is also learning about ignorance.
Many people repeat sentences like “where there is opportunity there is risk”, and “the greatest risk is not taking any risks”. But risk does not happen by accident. We cannot predict the future with absolute accuracy, but we can localize and identify plausible scenarios. A poker player doesn’t know exactly what the next card will be dealt, but he knows how to map out the scenario and place the appropriate bets so that even if he loses, the loss is part of the victory[5]. On the other hand, jumping off a cliff and hoping you would survive can’t really be called “taking risk”.
Most of us have a stable perception in assessing short-term risks, for example when crossing the road we will tend to slow down in the opposite lane, or accelerate faster to avoid a vehicle that may suddenly turn around a bend. Humans are equipped with a survival capability consisting of two closely related systems of intuition and analysis, allowing the brain to quickly resolve ambiguity to take action in the face of a threat. It simply decides what the ambiguity is, analyzes and fills in the missing pieces, draws order from the disparate information. However, long-term financial investing — or venture capital in particular — is often more complicated, due to the fact that our brains are inherently excellent at dealing with ambiguity in the face of immediate risk, but not really perfect in an intelligent long-term direction. Not to mention, long-term problems are more complex, and the information received is often imperfect.
As a result, investment decisions are often based on specific strategies that involve the “unknown” from the start i.e. imperfect information, rather than waiting for certain results. In which, “high risk — high return” is a popular strategy: the higher the risk, the more attractive the profit must be. The calculation is quite simple: the rate of return must be higher than the risk incurred. It’s not about how high the risk is, it’s about how big of a return that high risk will deliver. For example, in a coin toss game, every time you guess correctly, you get 150% of your bet, so your profit is 50%, you should always accept the bet, regardless of the risk up to 50%. Similarly, even if venture capital investment may come with a 90% chance of failure, but the promised reward is 1000 times the original investment, it is still a lucrative business as long as you have enough money and time to play the long game.
However, not everyone enjoys a 10% win in exchange for an 11x stake, as people realize that their lifetime and number of choices are limited. As a result, many people prefer 90% winning deals that yield 10% more profits. These two groups are two common risk appetites among investors, opposite of each other. However, both suffer from common rational errors, as well as being influenced by judgments made by their own nervous systems or by inadequate life experience.
Daniel Kahneman did an experiment where, when people were asked to take a certain loss or accept a gamble — which could lose more money or potentially break even — people were more likely to put their truth in gambling with hope for good fortune, a practice known as “loss aversion”. Two professors at the Santa Clara Leavey College of Business — Hersh Shefrin and Meir Statman — used this sense of loss aversion to explain the tendency to hold on to losing stocks for too long, but sell off stocks that could be profitable very quickly, and called this bias the Disposition Effect [6]. The general sentiment born of this effect often goes something like, “What’s going up must go down, and what’s going down must go up.” Based on this speculation, investors do not want to “cut loss” for immediate loss but continue to wait, as well as want to “take profit” immediately to avoid future loss. The illusion of control will cause investors who hold many stocks to overestimate the probability of success, while underestimating the risk, they often even ignore signs opposite to inherent opinion, leading to senseless investment behavior.
Calculating risk and return can help investors make more rational decisions, regardless of the actual outcome. Normally, the stop loss order should be given quickly when the loss is still hover below 10% (because you only need to profit 10% to break even), or higher if the investor’s financial health is not really good (loan, their own families are lacking money, investment amount accounts for too much % of total assets, do not want to invest anymore…) or the market already has a sure answer (your investment turns out to be a scam). In other cases, it is relatively pointless to cut losses when the loss is too heavy because you may miss the chance of the market recovering, as well as the chance for you to break even is even lower than the chance of the market recovering (for example, if you lose 50% of your capital, you need to make a profit as high as 100% to get your capital back to the start). Or in case the value of your investment is increasing, investors can completely lock in their capital with a little profit and let the rest run as wild as possible (maximizing profits at the same time minimizing risk).
Of course, investors must accept that, the higher the return, the greater the risk and vice versa, the lower the risk, the less profit.
3. We have been, are and will always be at risk; as well as was, is and always will be stupid
But that’s okay.
The biggest problem with the risk-and-reward narrative is that while the risk is absolute (whether you realize it or not), the feeling of profit is highly personal. An office worker can defy the risk of an accident or be fined when he’s speeding on the street to get to work on time, the profit he expects in the end is just not being late for his punch in. Similarly, believing the world is completely rational, we wouldn’t understand why some people choose to pursue a career in extreme sports over being a teacher or other safe traditional profession. Although everyone knows how to weigh risk — profit, each person has independent judgments about profit and the decisions made are therefore also extremely diverse and unpredictable. It is this sentiment in the evaluation of returns that also makes it difficult for us to say that an investor who stubbornly holds on to depreciating stocks is “stupid”, because they are most likely not only aiming for profits in money. Chances are they’re just looking for the feeling that they were right, or at least, have stood by their decision.
In all fairness, the world economy will be in trouble if people are no longer willing to spend money to invest, new inventions will not be possible because no one wants to bet on something completely alien, or closer, no one will dare to go out after knowing that every day many people die because of traffic accidents. This world thrives because there are always people who dare to take risks. Meanwhile, the living world moves very slowly. A thousand years ago, deer were afraid of tigers, and still do today. No herd of deer has ever worked together to fight back a single tiger, even though it is theoretically possible. The human world is constantly changing, with small nations ready to face empires to win back their freedom, because they dare to take risks and bet on the impossible.
There is always a place where you can stand and judge that someone is too stupid, from a gambler who loses all his salary every month, to someone who leaves his family behind to go to war, because of the profit calculation mechanism — human risk is often very personal and anyone can see the return on others as not worth it. But collective values, strangely enough, are shaped by these highly individual decisions.
For every one hundred “fools” who dare to step forward, humanity takes one hundred steps forward. Looks like this profit is well worth the bet.
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References:
[1] CB Insights, “From Alibaba To Zynga: 45 Of The Best VC Bets Of All Time And What We Can Learn From Them,” CB Insights Research, 09-Jun-2021. [Online]. Available: https://www.cbinsights.com/.../best-venture-capital.../. [Accessed: 11-Aug-2021]
[2] “amygdala | Definition, Function, Location, & Facts | Britannica,” Encyclopædia Britannica. 2021, Accessed: Aug. 12, 2021. [Online]. Available: https://www.britannica.com/science/amygdala.
[3] P. Rakic, “Evolution of the neocortex: a perspective from developmental biology,” Nature Reviews Neuroscience, vol. 10, no. 10, pp. 724–735, Oct. 2009, doi: 10.1038/nrn2719.
[4] “Stumbling on Happiness: Daniel Gilbert | Blog | July 2006,” Randomhouse.com, 2021. [Online]. Available: http://www.randomhouse.com/kvpa/gilbert/blog/200607.html. [Accessed: 11-Aug-2021]
[5] Monster Box, “Monster Box — [English Below] Facebook.com, Jul-2021. [Online]. Available: https://www.facebook.com/.../a.196200706.../2976990662581680. [Accessed: 11-Aug-2021]
Monster Box, “Monster Box — [English Below] Facebook.com, Jul-2021. [Online]. Available: https://www.facebook.com/teammonsterbox/photos/2975413786072701. [Accessed: 11-Aug-2021]
[6] M. Pompian, “Behavioral Finance and Wealth Management How to Build Optimal Portfolios That Account for Investor Biases,” [Online]. Available: http://www.untag-smd.ac.id/.../FINANCE%20Behavioral...
